Emerging markets & inflation

By Kurt Brouwer

Even before the unrest in Tunisia and Egypt took hold, there was another problem that was causing formerly emerging markets to submerge. That problem: inflation. Countries as diverse as China or Indonesia made their way out of the financial panic of 2008 by means of government monetary stimulus among other means. That has worked well, but the end result has been a rise in inflation.

This chart demonstrates what has been happening in several emerging countries to both their national stock markets and to bonds in the local currencies:

This chart covers a 30-day period ending January 27, 2011. The Wall Street Journal piece accompanying the chart made some excellent points [emphasis added]:

…In many emerging-market countries, inflation is already running near the top of official target ranges. Indonesia and Turkey are seen at risk of falling behind in the inflation fight—if they haven’t already—which could force much more aggressive rate increases down the road. This is especially bad news for bond investors, who see the value of their fixed-income returns eroded as inflation rises…

As we have seen in Tunisia and other countries, higher inflation means potential civic unrest as higher food and fuel prices lead to hardship. For emerging countries, inflation is not just a financial threat, but rather it is also a serious threat to government stability. And, my experience suggests that governments — and government leaders — view threats to their leadership seriously.

As a result, steps are being taken to rein inflation in across many developing nations and this is likely to slow down economic growth. Ideally, countries want to slow things down without driving the economy into a recession. Unfortunately, that is not easy and stocks markets and bond markets have reflected this fact.

The article continues with information on what has happened in several emerging markets as fears of inflation have taken a toll on their financial markets:

…Indonesia was an investment darling last year. Foreign investors have funneled $9.4 billion into government bonds since the start of 2010 and now hold 30% of all outstanding government debt, compared with 15% last March. That buying helped 10-year local-currency bonds hit a low yield near 7% at the beginning of the year.

However, since then, inflation concerns have caused a punishing selloff. Foreign investors sold $1.3 billion in Indonesian bonds from Jan. 7 to Jan. 26, according to the government, taking yields on those same bonds to nearly 10%. Yields drifted back below 9% in the past few days.

As yields rise, prices fall. Broadly, Indonesian local currency bonds have lost nearly 5% of their value in just the past month, according to Barclays Capital.

“Indonesia is the one that offers the most worrisome precedent for other countries whose central banks might wind up behind the curve,” says Michael Gavin, head of emerging-market strategy at Barclays…

These countries are trying to slow inflation without triggering a recession. That is, to make a ‘soft’ landing, economically speaking. In some of these countries, that ‘soft’ landing may not be possible, in part because many emerging countries peg their local currency to the dollar.

Unfortunately, even though those countries are attempting to fight inflation, the Federal Reserve is actively attempting to ignite inflation here at home. The side effect of this is that countries with currencies pegged to the dollar are hampered in their inflation-fighting efforts. For more, see Inflation & the dollar crisis.

The Wall Street Journal piece continues:

…Complicating matters are the ripples from the Federal Reserve’s efforts to continue pumping money into the U.S. financial system.

For countries that are keeping their currencies largely pegged to the U.S. dollar, “emerging markets are in effect importing a much more lax monetary policy from the U.S. than would be suitable,” says Natalia Gurushina, director of emerging-markets strategy at Roubini Global Economics…

In other words, having an inflexible currency is a problem when economic changes occur. We saw that in Europe with Greece, Ireland and other countries that had weak economies, high debt and soaring deficits. Normally, in those circumstances, a given country would allow its currency to weaken, but those countries could not do so because they use the euro.

In the case of countries that peg their local currency to the dollar, they also have side effects from currency inflexibility. One of those side effects is difficulty fighting inflation when the Federal Reserve is trying to ignite it.

Boom & bust cycles

In terms of future growth potential, I believe emerging economies are going to do very well. However, as happened here in the U.S. earlier in our history, high rates of growth are generally accompanied by higher volatility and a propensity for boom and bust cycles.

As an investor, you can either try to get ahead of those boom and bust cycles by actively trading or you could stay out altogether.

My approach is to invest in those emerging economies, whether in stocks or bonds, with a patient, long-term perspective.

However, it is very important to be aware of potential periods of over valuation or under valuation. Investors can and do get carried away with enthusiasm for a given asset class as we saw above in the case of Indonesian bonds. For more information on this, see Is there an emerging market bond bubble?

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.